The US is set to impose massive tariffs on China in the first week of September.

The move has significant consequences for the global economy and currencies.

Here are three scenarios for the significant escalation and the potential forex reactions.

The US imposed tariffs on $50 billion worth of Chinese imports so far. China has retaliated with duties on the same scale. The mere talk of imposing levies has already caused some postponement in global investment decisions. The first round of tariffs that mostly came into force in early July already produced some front-loading of trade to Q2.

The upcoming tariffs on $200 billion worth of goods are a whole new ballgame.

Significant trouble looming

The US, the world's largest economy, imports around $500 billion worth of Chinese goods annually. Slapping tariffs on 10% of trade are entirely different from doing so on 40%. China, the world's second-largest economy, imports much less American goods.

While it cannot match the $200 billion level in retaliatory duties, it has pledged to slap tariffs on $60 billion worth of US products and may also add non-tariff barriers and hurdles to US companies operating in the Middle Kingdom.

The US move and the response from China have consequences for companies in other countries as well, especially in Asia. Supply chains are distributed worldwide. A leap in trade hostilities could grind the growing global economy to a halt.

President Donald Trump has also threatened to go to the "full $500 billion", meaning that after the upcoming duties, more may be in the pipeline.

The Administration is set to conclude its findings on September 6th and tariffs may be imposed as early as that date or on the following day, September 7th. Trump and Commerce Secretary Wilbur Ross both said that this is not the time to talk to China.

Sanguine markets so far

Markets have been relatively confident so far as the US and other economies continue posting robust rates of growth. This is unusual for markets that usually speculate on future developments rather than past ones.

A better reason to reason to be optimistic is the latest breakthrough in the North American Free Trade Agreement. The US and Mexico cut a deal to replace NAFTA which is not entirely different from the current agreement which dates back to the 1990s. Canada is set to join shortly. The accord was cheered by equity markets and the US Dollar dropped. Trump made one trade deal and will make another one with China, goes the logic.

A third reason is political. Americans go to the polls for the mid-term elections in mid-November. So, the push against China is mostly a political move designed for domestic politics and nothing else. And once the elections are over, Trump will change tack, regardless of the results.

Are markets right or wrong? We will know soon enough.

Here are three scenarios:

1) Tariffs go through

All the signs show that Trump and his colleagues are bent on hitting China with the whopping levies on $200 billion of imported Chinese goods. It may account solely for political reasons or maybe to squeeze concessions from China.

The scenario has a high probability and is far from being priced in.

In this scenario, the US Dollar surges on safe-haven flows. The Japanese yen may also enjoy such flows, but the strength of the yen depends on the magnitude of the downfall in stock markets. The deeper stocks fall, the deeper the yen drops.

The euro and the pound will likely succumb to the greenback's pressure. However, the Swiss franc may enjoy some minor safe-haven flows of its own.

Commodity currencies will likely split between the Canadian Dollar and the rest. The loonie may not bear the full brunt of USD strength thanks to the new NAFTA deal. However, the Australian and New Zealand dollars which depend on China may tumble.

2) Temporary trade truce

China and the US have been talking in recent months yet without any conclusions. The negotiations between the European Union and the US resulted in a truce: no new tariffs for now. This accord may be a last-minute resolution for the world's largest economies. A decision to put off new duties and to talk may be temporary, but it could have significant consequences for currencies.

This scenario has a medium probability.

In the case of a trade truce or a delay in tariffs, markets will cheer, but the moves will be limited. The US Dollar will likely be on the back foot and so will the yen.

The euro and the pound will likely take advantage of the news with a broader relief rally in the Australian and New Zealand dollars. Asian currencies could pick up as well.

As such a scenario provides only temporary relief, the moves may be limited and temporary as well.

3) The art of the tremendous deal

Trump reached an agreement with Mexico and declared victory even though there are no substantial Mexcian concessions to the US. He may do it with China, agreeing to some minor changes and taking a victory lap. That would please both Republicans donors who want free trade and also his anti-trade base.

This scenario has a very low probability, as it assumes negotiations are going on in the shadows and that Trump changed his basic stance. However, it is not impossible, as the President has surprised markets in the past.

In this scenario, markets are set for a broad and long-lasting rally, the US Dollar tumbles down, and the yen follows suit.

The euro and the pound take advantage of the move, albeit with the pound lagging behind on Brexit concerns.

The Australian and New Zealand dollars and emerging market currencies leap, while the loonie advances but without fireworks.

Conclusion

Tariffs on $200 billion worth of Chinese goods is a major gamechanger in commerce and could mark a turning point for the global economy and for currencies. The duties have a good chance of going through and are likely to result in a surge in the US Dollar. There are two other better scenarios for markets that cannot be ruled out.

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